Is the Oil Industry Now Underinvesting? (OIL)

The saying goes that the cure for low oil prices is low oil prices. The idea is that as prices fall, investment declines, which in turn reduces output and increases prices. That saying hasn’t held true just yet. Oil prices are currently down 72% from the high in June 2014, and investment in higher cost oil plays is being shelved, but supply remains stubbornly high and keeps prices low for the time being. Just this week the US Energy Information Agency (EIA) reported a record build in U.S. crude oil inventories. Saudi Arabia repeated that it had no plans to cut output and would continue to protect its market share despite an agreement reached in Doha, Qatar between some OPEC members and Russia to freeze oil production at January 2016 levels, according to CNBC.

Companies are doing what they can to cope with a new low oil price environment, specifically when it comes to cutting investment spending. Estimates vary, but according to the Oil and Gas Financial Journal, currently $200 billion of projects have already been pulled due to low oil prices. The Financial Times (FT) of London reports that across the industry, some $400 billion in expected investment has been canceled or delayed. This is a shocking figure considering it wasn’t that long ago when the market expected companies’ capital expenditure (CapEx) budgets to continue growing. (For more, see: CAPEX Spending In the Energy Sector Keeps On Growing.)

Energy Sector Under-investment

With companies aggressively slashing investment budgets some analysts are beginning to ask if the stage isn’t being set for the next oil supply drought. Investment spending is needed today to have oil tomorrow, and expectations are that demand will outstrip supply over the coming ten years. For example, BP published its Energy Outlook to 2035 in February 2016 where they estimate total oil production to grow by 8.1% to 2025. Over that same period, BP projects oil consumption to grow by 11.8%, with the strongest demand coming from the industrial and transportation sectors. If these forecasts prove to be correct then at some point the market will come into balance. The key is not to overshoot to the downside in the meantime, laying the groundwork for the next supply crisis.

Current spending patterns suggest that is exactly what could be happening with oil and gas sector investment spending in 2015 down roughly 24% as companies cut spending to preserve cash flow. Data from FactSet and the Oil and Gas Journal (OGJ) report similar figures for 2015 spending reductions. FactSet’s data is based on energy companies in the S&P 500 index, while the Oil and Gas Journal is a survey of 71 independent exploration and production (E&P) companies and ten large integrated players.

Analysts are equally concerned by the accelerating rate of reduced investment spending in 2016. The chart below from FactSet shows that they are predicting a 27.7% decline in energy CapEx for 2016 and only a mild stabilization in 2017 of less than 1% growth. More concerning is that the 2017 spending forecast is based on an average target price of crude oil in 2017 of $53.41 per barrel, according to FactSet commodity estimates. That is 80% higher than oil’s closing price this week.

The Oil and Gas Journal provides additional insight into future investment spending. They report similar data to FactSet concerning overall CapEx reductions in 2015, but they provide additional insight regarding the state of US E&P companies specifically. For example, their survey of 71 independent E&P companies found that 2015 spending cuts were more aggressive than the sector as a whole, declining on average by 48%. The Oil and Gas Journal survey predicts U.S. E&P companies could reduce CapEx by another 29% in 2016. The reason for this is because E&P companies are more closely tied to the fate of the oil price, whereas integrated operators are diversified and benefit from selling refined products. OGJ’s survey of 10 large integrated companies shows that, on average, their budgets should decline by 10% in 2016 after cutting spending by 9% in 2015. This is substantially less than the pure upstream E&P operators.

The chart below from Reuters shows most major oil companies will reduce spending in 2016. Data from Royal Dutch Shell includes investment spending from their recent purchase of BG Group. (For more, see: Does the Shell/BG Merger Still Make Sense?)These forecasts are likely to be revised lower now that the merger is completed as Shell works to fulfill its pledge to reduce spending.

The Bottom Line

Oil companies play the long game to survive in this industry, and oil sector investments are multi-billion dollar projects that can take several years to deploy. Investments need to be made today to have oil for tomorrow. A minimum level of investment is also needed simply to deal with natural decline rates in production, which tends to average around 6% per annum. If crude oil demand picks up in any meaningful way in the years ahead, we could find that today’s investment cuts will come back to bite us in the wallet at the petrol pump.